State and Local Public Policy from the Mercatus Center

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Does Progressive Taxation Make State Budgeting More Difficult?

Virtually every state reported growth in overall tax collections as well as in tax collections from two major sources: personal income tax and sales tax.

That is according to the Nelson A. Rockefeller Institute of Government. Their new report examines preliminary tax data for the January-March quarter of 2011. In the median state, total tax revenue is up nearly 11 percent, with the two fastest-growing components being corporate income tax revenue (up 10 percent) and personal income tax revenue (up 14 percent).

It should not surprise that states reported the most growth in these two taxes: These are the most-progressive forms of taxation at the state level, so it stands to reason that these would be the most-responsive to changes in economic conditions. When the economy is growing, individuals and corporations make more money, are pushed into higher tax brackets, and fork over larger percentages of their higher incomes to the state. (Since many states fail to index their tax brackets for inflation, “bracket creep” forces many into higher brackets even though their real incomes–as measured by their purchasing power–are unchanged.)

One might conclude from this data that progressive taxes like these are the panacea for state budget woes. They are not. Just as these types of taxes generate a revenue boom during good years, they also tend to lead to a bust during bad years. In fact, I’d argue that the states’ gradual shift away from flat sales taxes toward progressive income taxes helps explain why states seem to have gotten worse at revenue forecasting in recent years. The Wall Street Journal had an informative piece on this phenomenon a few weeks back. There is also a nice paper by Alison Felix of the Kansas City Fed examining the most-volatile sources of state tax revenue.

To see if progressive taxation has anything to do with states’ current budget woes, I gathered data on 2010 state budget gaps from the Center on Budget and Policy Priorities. I used their figure “Total gap as a percent of FY2010 general fund” and then ran a simple regression, controlling for regional effects, to see whether reliance on different tax instruments might impact the size of a state’s budget gap. Using pre-recession (2007) data from the Census, I calculated the percentage of tax revenue each state typically obtains from each of six sources: personal income taxes, corporate income taxes, general sales taxes, selective sales taxes, licenses, and other taxes (using pre-recession data diminishes the chance of an “endogeneity” problem whereby the regression picks up the recession’s impact on both revenue shares and budget gaps).[1]

Among the six varieties of taxes, the share of revenue coming from two of them was statistically significantly related to the size of states’ 2010 budget gaps: the personal income tax share (significant at the 1 percent level) and the corporate income tax share (significant at the 10 percent level). Other factors being equal, a ten percentage point increase in a state’s reliance on personal income taxation increased the state’s budget gap by 3.7 percentage points (or 2.85 standard deviations). The partial regression plot shows the estimated effect. The horizontal axis depicts states’ share of taxes collected through the personal income tax, while the vertical axis shows states’ budget gaps as a share of general fund spending. The upward-sloping line indicates the positive relationship between reliance on personal income taxation and budget gap size:

Reliance on the corporate income tax seemed to have an even greater impact on the size of a state’s budget gap. Other factors being equal, a 10 percentage point increase in a state’s reliance on the corporate income tax tended to lead to an 8.7 percentage point increase in the size of a state’s budget gap (6.78 standard deviations). Here, the horizontal axis shows the share of tax revenue derived from the corporate income tax while the vertical axis again shows the budget gap. Notice the wider-dispersion of data points (lower level of statistical significance) and the steeper line, indicating a more-powerful effect:

These are relatively simple regressions. It’d be interesting to see if the same results hold with more-sophisticated anlyses. In sum: it appears that progressive taxation seems to be a recipe for rapid revenue growth when the economy is expanding (even tepidly). But it also seems to lead to larger budget gaps during recessions.

[1] Each of the tax shares sum to 100 percent. So if I included all six in the regression, it would be perfectly co-linear; I therefore dropped the “license share” from the regression.